In this month's market commentary, Mike Bell, discusses the most asked question from clients recently – are we heading back to the 1970s? As higher energy prices and food prices increase, putting upward pressure on inflation, Mike explores whether we're really heading back to that era.
Are we heading back to the 1970s? That's a question I've been getting a lot recently from clients. It's understandable why they're thinking that. Bond yields keep rising, and the near-term risks to inflation are likely to the upside, given negative supply shocks like we saw in the 1970s, putting upward pressure on energy prices, and potentially food prices. In my latest thought piece, I argue that medium-term, there are reasons to doubt that we're heading back to anything like the kind of inflation and interest rate environment we saw in the 1970s. Ultimately, what drives inflation in the medium-term is the difference between wage growth and productivity growth, or what economists like to call unit labour cost growth. When you look around the world at the moment, unit labour cost growth is nowhere near as high as it was in the 1970s. The key question as higher energy and food prices put upward pressure on inflation is, is that going to transmit into higher wage growth? Now, in the US, there's some reason to fear that you might see a bit of a pickup in wage growth. Unemployment is still relatively low, the labour market's relatively tight, and if anything, seems to be stabilising. Also in the US, productivity growth is running at a decent clip. When you look in some other economies, for example here in the UK, the labour market is much weaker. That all else equal would suggest that wage growth is unlikely to accelerate meaningfully. However, here in the UK, we do have the problem that you get more of an impact from minimum wage increases and public sector gains that could put upward pressure on wage growth, despite a weakening labour market. It's important to watch the tightness of the labour market, and the extent to which headline inflation shocks pass through into wage growth carefully. Medium term, though, I think we need to think very carefully about AI, and what impact it could have both on productivity growth, but also workers' bargaining power, and hence wage growth. If AI lives up to its promise and boosts productivity growth, then that could help keep unit labour costs lower, and hence mean that we don't get the kind of inflationary pressures that some are currently worried about in the medium term. In a more severe scenario, it's possible that AI not only leads to higher productivity growth, but could also potentially lead to net job losses, and hence reduce worker bargaining power, and put downward pressure on wages. It's not impossible that in a few years' time we look back and think, actually, with the benefit of hindsight, perhaps, it was obvious that AI was posing a disinflationary and maybe even deflationary risk to the medium-term outlook for inflation, whereas at the moment, everyone seems much more focused on the near-term upward pressures on inflation coming from higher oil and food prices. I just caution everyone not to get too caught up in the very near term, and to think about the medium-term outlook for inflation which, as I say, is driven by wage growth relative to productivity, and to think particularly about how AI could influence that going forward. A final point to consider, the sustainable level of interest rates is dependent on the amount of debt relative to incomes. That was relatively low in the 1970s, but today is much higher. The idea that interest rates can sustainably return to the kind of levels we saw in the 1970s doesn't make much sense to me. Check out the latest thought piece for more information and some charts to back this all up. If you have any questions, please reach out to your RBC BlueBay sales contact, and I'll look forward to discussing it with you in more depth.
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